The Future Is Gas

LONDON -- "It's really a gas and wind world today," Jeff Immelt told the Financial Times while visiting London for the Olympics. He should know; he's CEO of General Electric, a company that manufactures across the whole spectrum of the energy sector. And he made clear that in most countries, gas and wind power -- with some solar thrown in -- are seen as the way forward.

It's a trend that is playing out in different ways for two FTSE 100 (UKX) companies, Centrica (ISE: CNA.L) and BG Group (ISE: BG.L) .

As if to underline Immelt's comments, last week the U.K. government announced measures to support the role of both gas and wind in the U.K.'s energy supply. It will give tax relief for shallow water gas field development in the North Sea, and it will cut the generous subsidies for onshore wind power by just 10% rather than the 25% lobbied for by Chancellor George Osborne.

North SeaThe North Sea tax measure had an immediate impact, with Centrica saying that it would go ahead with a 1.4 billion pound investment in the Cygnus gas field.

That fits with Centrica's strategy of matching its retail gas and electricity supply business with upstream production. Its strategy is to hedge fluctuations in retail margins against fluctuations in wholesale margins, which tend to move in opposite directions.

It's a strategy that seems to be paying off. In the first half of the year, adjusted operating profits were up 15% on revenues of just 4%, with the upstream U.K. business delivering a 28% increase and the U.K. retail business rising 9%.

It's a very different story for BG, which saw its first-half operating profit down 25%, after a $1.3 billion noncash writedown on its gas reserves. The reason: BG has invested heavily in the shale gas sector in the U.S., where a glut of supply and the economic downturn have pushed gas prices down to a quarter of their European equivalent.

Shale gasThe shale gas revolution has transformed the U.S. energy sector. By combining technologies of horizontal drilling and hydraulic fracturing, or fracking, it has become commercially viable to extract natural gas trapped in shale rock, one of the most abundant rocks on Earth. It's estimated that the U.S.' reserves could last for 100 years.

Fracking is controversial. It involves pumping a mixture of water and sand into sedimentary rocks to force natural gas, or oil, to the surface. If it goes wrong, it has the potential to contaminate water supplies, and even cause earthquakes.

But the benefits of a cheap resource and energy security mean its future looks secure. The U.S. aside, Mexico, Argentina, South Africa, China, Australia, Canada, Brazil, and Libya all have massive reserves as well. There are prospects in Europe, too, including the U.K.

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LNGBG's asset writedown was explicit recognition that U.S. gas prices have been permanently reduced. But the company has an ace up its sleeve. As a vertically integrated gas company, it can ship liquefied natural gas around the world. Its long-term strategy is to sell cheap U.S. gas in higher price markets, exploiting the fact that, unlike oil, the price of gas varies region by region.

It's also cutting back production of U.S. shale gas, a strategy being followed by others in the sector, such as Royal Dutch Shell. That's likely to help stabilize prices.

BG is at a turning point. The experienced management team has enjoyed great exploration success, especially in Brazil, and is now in the process of turning discoveries into production. That requires massive capital expenditure. The long-term growth profile is attractive, but the execution risk is considerable, too, and the shares have dropped more than 10% in the past year.

Share Price

P/E (TTM)

Dividend Yield%

BG

1,282 pence

19

1.2%

Centrica

322 pence

18

4.9%

Centrica is the more defensive stock, with a juicy 5% yield.

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